A New York bankruptcy judge's position on the Sabine Oil & Gas case could dramatically alter the balance of power in the midstream energy market.

New York bankruptcy Judge Shelley Judge Chapman ruled a debtor, Sabine Oil and Gas Corp., could reject, or breach, its gas treatment and gathering contracts with two midstream companies March 8.

In a procedural twist, however, she determined that she could not rule – without further proceedings – on whether certain covenants in the contracts were, in fact, covenants “running with the land”, which cannot be affected by the rejection of the contract. She wrote a “non-binding” opinion that the covenants, which included the dedication of hydrocarbons from certain leases and covenants to pay gathering fees to the midstream companies, were not covenants running with the land under Texas law.

Unless Judge Chapman changes her mind when the issue is ripe for her “binding” opinion, the midstream companies could lose all of their rights under the contracts and be relegated to unsecured creditors in the case.

Stephen Roberts

Partner, Strasburger and Price LLP

What makes this case particularly significant is that the contracts at issue are similar to those used throughout the industry and, until now, were believed to be the type of contracts a debtor could not reject in bankruptcy. Midstream companies collectively invest billions of dollars annually in developing the infrastructure necessary to gather, process, and transport oil and gas. In exchange, they receive a promise of payment, if and when oil and gas is produced, as well as dedications of the underlying oil and gas mineral interests and associated acreage. The contracts characterize these dedications as covenants running with the land, and they record them in the real property records. The contracts are not only binding on the parties to the contracts, but also upon anyone who acquires the mineral rights in the dedicated area. This serves to protect their substantial capital investment and protect the benefit of their bargain.

Or so they thought.

The bankruptcy code permits a debtor to “reject,” or breach, an “executory” contract that is burdensome to the estate, with court approval. There is no definition of an executory contract in the code, but the case law has generally defined an executory contract as one in which both parties have an ongoing obligation to perform after the date of the bankruptcy filing. However, the case law has excluded rights that run with the land from the definition of executory contracts. So, for example, deed restrictions may meet the definition of an executory contract, but they cannot be rejected because they are binding – not only upon the parties to the contract, but also upon anyone who acquires the land burdened by the deed restrictions.

Judge Chapman wrote, in the “non-binding” portion of her opinion, that the covenants were not truly covenants running with the land under Texas law – even though the parties had agreed they were – because the convenants did not reserve an interest in real property. They just delineated the terms of the parties’ contract for providing services. In other words, just because the parties said it was so, didn’t make it so.

Judge Chapman’s opinion will not be the last word on the subject. The same issues have been taken under advisement by bankruptcy judge Laurie S. Silverstein in the Quicksilver Resources Inc. case, which is pending in the Bankruptcy Court in Delaware. In that case, the opposing parties have framed their arguments differently and are being supported by an amicus brief filed by the Gas Processors Association and the Texas Pipeline Association. A ruling is expected soon.

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